Market Multiple Analysis| Price Earnings (PE), EBITDA, Revenue
Last Updated by WikiWealth
Multiple, in financial terminology, is a metric used in the valuation of companies. The most commonly used multiples are: P/E (Price earnings ratio), EV/EBITDA (Enterprise value to Earnings before Interest, Taxes, Depreciation, and Amortization). In some industries, sector-specific multiples are also used, such as EV/capacity, EV/output.
Multiple analysis is a method for determining the current value of a company by examining and comparing the financial ratios of relevant peer groups, also often described as comparable company analysis or comps). The most widely used multiple is the price-earnings ratio (P/E ratio) for stocks in similar industries. Using the average of multiple improves reliability, but adjustments are still necessary.
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What is the Market Multiple Analysis
Market Multiples (also called, comparative investing multiples, trading multiples, market multiple approach, comparable company analysis, relative value analysis): A comparison between two financial measures used to determine the value of a target company. The most common methodology for individual equities is based on comparing certain financial ratios or multiples, such as the price to book value, price to earnings (PE), EV/EBITDA, etc., of the equity in question to those of its peers. For example, if one companies' stock price trades at a EBITDA multiple (value/EBITDA) of 5.0x, then a similar company can be expected to trade at a similar multiple in the market place. To find the value of the target company, multiple the 5.0x times (value/EBITDA) the target targets companies EBITDA number. The result of this example will give an analyst the value of the target firm. Accuracy of any ratio depends on the similarity of the companies in question.
Importance of Market Multiples to Investors
Market Multiples rely on the similarity of companies. Similar companies will likely trade along the same multiple range. When there is an outlier for the range of companies, it is important to understand why that particular company is trading at such a multiple. If a company is trading at a multiple below the rest of their peers, that company is considered undervalued, because it has a higher chance to increase in value. For example, if a target company trades at 1.0 times EBITDA, but their peers are trading at 5.0 times EBITDA, then the target company could potential increase by 5 times just to reach the valuation assigned to their peer group; the opposite is also true.
Dissimilar Companies Make Valuations Difficult
Dissimilar companies can make valuations difficult. It's like comparing apples to oranges. This occurrence can be dangerous for investors who think two stocks are similar, but trade like completely different companies. If the expectation that one company will increase in price because of a certain positive event, the wrong peer group may indication the opposite movement in price. For example, gas stations and oil companies both rely on gas to increase their profits; however, when the price of gas increases, gas stations suffer and oil companies benefit. If an analyst thought these companies were similar, they would purchase an investment expecting one find of reaction to news, but get the opposite.
For example, if you have one red car selling for 5,000 dollars and an identical red car with no selling price on it, you can assume that the cars - if truly similar - would sell for the same price. Any differences are easy to spot and evaluate. Unfortunately, differences in companies can be very minute, but have big consequences in performance. The difference between Target's business and Walmart's business is a slight difference in customer income levels; otherwise, these companies are nearly identical.
This difficulty also explains outliers. An outlier might exist, because it its fundamentally different from it's peer group. Therefore, it might stay as an outlier forever.
How do Market Multiples Such as the EBITDA, PE, and Revenue Multiple Fail?
Multiple rely on the stock market determine the appropriate price for an investment. When these factors are controlled, multiple analysis can accurately provide a financial comparative measure for your target company. The stock market is prone to periods of irrational exuberance and irrational pessimism. During these periods, entire groups, industries, and sectors can increase or decrease in price. If the price of an group of stock is such that their multiples all agree, then how can an analyst identify an undervalued or overvalued company in the group? Their are two ways to control for this problem.
- An analyst can compare the current multiple with multiples from previous years. This will give an analyst an easy estimation of value; unfortunately, past multiples could also be wrong. What if the business fundamentally changed over time? The past multiple would not be relevant in that case. Additionally, there is no telling if the past multiple was correct either.
- A better way to find whether a company is over or undervalued is to use the discounted cash flow method, which estimates company valued based on the company's ability to create cash flow.
- Capital asset pricing model
- Weight Average Cost of Capital (WACC)
- Beta Coefficient
- Country Risk Premium
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- Discount Rate
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- Equity Risk Premium
- Free Cash Flow
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- Private Equity Discount Rate
- WACC Calculator
- Market Approach Template
- Basis Market Approach Template
- Firm Multiples
- Risk Free Rate 1
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- Risk Free Rate 3
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- Cost of Debt (required return)
- Search for Betas
- Treasury Yield
- Cost of Debt - Corp Bond Yields
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